Simon Benninga. Financial Modelling 3-rd edition

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178 Chapter 5

we rewrite the balance sheet by moving the current liabilities from the

liabilities/equity side to the asset side of the balance sheet:

Assets Liabilities

Cash and marketable securities Operating current liabilities

Operating current assets Debt

Net fixed assets Equity

Goodwill

Total assets Total liabilities and equity

Assets Liabilities

Cash and marketable securities

Operating current assets Debt

- Operating current liabilities

= Net working capital

Net fixed assets Equity

Goodwill

Market value Market value

NONFINANCIAL FIRM:

USING THE BALANCE SHEET AS AN

ENTERPRISE VALUATION MODEL

ORIGINAL BALANCE SHEET

THE ENTERPRISE VALUATION BALANCE SHEET

Enterprise value

= PV (FCFs

discounted at WACC)

The enterprise value is computed by taking the present value of the

ﬁ rm’s free cash ﬂ ows (FCF):

Enterprise value

Discounti

⎡

⎣

⎢

⎤

⎦

⎥

∗+

∑

FCF

WACC

()

nng

all FCFs

Terminal valueFCF

WACC WACC

()()11

⎡

⎣

⎢

⎤

⎦

⎥

∗

∑

(()

⎧

⎨

⎪

⎩

WACC

Terminal value

proxies for PV

of FCFs past

date

⎪⎪

⎪

The (1 + WACC)

0.5

term relates to midyear discounting (discussed in

section 3.5.3). The most common terminal-value model (see section

3.5.1) is based on the assumption that the last projected free cash ﬂ ow

will continue to grow at a long-term growth rate. This growth rate,

denoted by “LT growth rate” in the following formula, need not be the

179 Bank Valuation

same as the short-term growth rate used to produce the projections of

the bank’s balance sheets and income statements:

Terminal value

LT growth rate

∗+

−

FCF

WACC

()1

To arrive at the market value of the ﬁ rm’s debt plus equity, we add the

cash and marketable securities to the enterprise value:

Market value Cash and marketable securities=

⎡

⎣

⎢

∑

FCF

WACC

()1

⎤⎤

⎦

⎥

∗+

∑

()

()()

WACC

FCF

WACC WACC

Terminal value

⎡⎡

⎣

⎢

⎤

⎦

⎥

∗+()

WACC

If we are valuing the equity of the ﬁ rm, we subtract the value of the

debt:

Equity value Market value Debt

Cash and marketable securities

=−

CCF

WACC WACC

WACC

()()

()

⎡

⎣

⎢

⎤

⎦

⎥

∗+

∑

Terminal value

−

⎡

⎣

⎢

⎤

⎦

⎥

∗

∑

Debt

Terminal valueFCF

WACC WACC

()()

( ++

−−

WACC)

()

.05

Debt Cash/Marketable securities

Essentially we are writing the enterprise balance sheet in a slightly dif-

ferent form:

Assets Liabilities

Operating current assets Debt - cash/marketable securities

- Operating current liabilities

= Net working capital

Net fixed assets Equity

Goodwill

Enterprise value Enterprise value

NONFINANCIAL FIRM:

ENTERPRISE VALUATION MODEL

Cash netted out from debt

Enterprise value

= PV (FCFs

discounted at WACC)

180 Chapter 5

5.2.2 Applying This Model to Banks

In the enterprise valuation model for nonﬁ nancial ﬁ rms, we lump together

all ﬁ nancial liabilities (whether classiﬁ ed by accountants as current lia-

bilities or as long-term liabilities) under the category of debt for a non-

ﬁ nancial ﬁ rm. Thus the net working capital in the preceding scheme

represents only operating current assets. When this logic is applied to

banks, a conceptual change is required: Banks borrow money (whether

in the form of deposits or of loans from other ﬁ nancial institutions or

markets) and then lend it out. It follows that when we are valuing or

analyzing a bank, we should distinguish between the bank’s borrowing

for the purpose of making loans and the bank’s permanent debt. (This is

not to say that this distinction can always be made in practice.)

Once we have made this conceptual distinction, we can apply the

enterprise valuation model to banks. The distinction between funds used

for the bank’s lending activities and funds used as part of the bank’s

longer-term ﬁ nancing means that there are some important differences

between banks and nonﬁ nancial companies:

•

On the asset side: For a nonﬁ nancial company, cash and marketable

securities are usually a store of value. For a bank, however, most marketable

securities (and some of the cash) constitute an operating current asset.

•

On the liability side: For a nonﬁ nancial company, we put all debt items

together, even if—from an accounting point of view—they are current

liabilities. Thus,

Debt (nonﬁ nancial company) = Long-term debt + Notes payable

+ Current portion of LTD + . . .

For a bank, most or all of the short-term debt items are operating current

liabilities and are therefore part of the bank’s working capital.

To stress this difference between nonﬁ nancial companies and banks,

we will analyze the balance sheets of two banks, Summit Bank and

Cullen Frost Bankers.

5.2.3 Example 1: Summit Bank

Summit Bank is a small New Jersey bank. Following are the Summit

Bank balance sheets for 1996 and 1997.

1. By permanent debt we mean essentially the same as Tier 2 capital (see box on

p. 183).

181 Bank Valuation

ASSETS 1997 1996

Cash and due from banks 30,487 28,339

Federal funds sold 35,760 20,350

Investment securities

Securities available-for-sale, at fair value 60,476 58,576

Securities held-to-maturity, at cost (fair value

of $45,360,000 and $58,629,000 at

December 31, 1997 and 1996, respectively) 45,151 58,437

Total investment securities 141,387 137,363

Loans, net of unearned discount 276,069 220,006

allowance for loan losses -4,065 -2,972

Loans, net 272,004 217,034

Premises and equipment, net of depreciation 7,916 7,105

Accrued income receivable 3,442 3,189

Other real estate 151 166

Other assets 4,407 2,052

TOTAL ASSETS 459,794 395,248

LIABILITIES AND SHAREHOLDERS' EQUITY 1997 1996

Noninterest-bearing demand deposits 126,398 103,695

Interest-bearing deposits 275,326 241,328

Total deposit

s 401,724 345,023

Securities sold under agreement to repurchase 14,689 13,209

Accrued interest payable 678 638

Other liabilities 1,591 1,298

TOTAL LIABILITIES 418,682 360,168

Common Stock 8,127 4,041

Capital Surplus 6,251 6,136

Retained Earnings 26,491 24,675

Unrealized gain on investment securities

available-for-sale, net of tax

243 228

Total shareholders equity 41,112 35,080

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 459,794 395,248

SUMMIT BANK

1996 and 1997,

(thousand $)

A careful examination of these balance sheets leads to the conclusion

that Summit Bank has no permanent debt. All the liabilities are funds

that have been borrowed in order to ﬁ nance the bank’s lending and

short-term investment activities and are therefore part of its working

capital. Summit Bank has no permanent debt capital, so that it is effec-

tively an all-equity enterprise. Rewriting the balance sheets to reﬂ ect this

fact gives us the following:

69917991STESSA69917991STESSA

933,82784,03sknabmorfeuddnahsaC 933,82784,03sknabmorfeuddnahsaC

363,731783,141seitirucestnemtsevnilatoT053,02067,53dlossdnuflaredeF

Investment securities

Securities available-for-sale, at fair value 430,712400,272teN,snaoL675,85674,06

Securities held-to-mmaturity, at cost (fair value

of $45,360,000 and $58,629,000 at

December 31, 1997 and 1996, respectively)

45,151 58,437

363,731783,141seitirucestnemtsevnilatoT

861,063-286,814-seitilibailmret-trohssuniM

600,022960,672net of unearned discount,snaoL

279,2-560,4-sessolnaolrofecnawollA

430,712400,272net,snaoL

501,7619,7noitaicerpedfoten,tnempiuqednasesimerP

981,3244,3elbavieceremocnideurccA

661151etatselaerrehtO

215,21619,51stessarehtodnadexifteN250,2704,4stessarehtO

080,53211,14EULAVESIRPRETNE842,593497,954STESSALATOT

LIABILITIES AND SHAREHOLDERS' EQUITY 1997 1996 LIABILITIES AND SHAREHOLDERS' EQ 1997 1996

596,301893,621stisopeddnamedgniraeb-tseretninoN

823,142623,572stisopedgniraeb-tseretnI

320,543427,104stisopedlatoT

902,31986,41esahcruperottnemeergarednudlosseitiruceS

00"tbedtnenamreP"836876elbayaptseretnideurccA

892,1195,1seitilibailrehtO

861,063286,814SEITILIBAILLATOT

140,4721,8kcotSnommoC140,4721,8kcotsnommoC

631,6152,6sulpruSlatipaC631,6152,6sulpruslatipaC

576,42194,62sgninraEdeniateR576,42194,62sgninraedeniateR

Unrealized gain on investment securities

available-for-sale, net of tax

243 228

Unrealized Gain on Investment Securities

Available-for-Sale, Net of Tax

243 228

ytiuqesredloherahslatoT080,53211,14ytiuqesredloherahslatoT

41,112 35,080

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 459,794 395,248 ENTERPRISE VALUE 41,112 35,080

SUMMIT BANK

1996 and 1997,

(thousand $)

SUMMIT BANK'S BALANCE SHEETS

IN ENTERPRISE VALUE FORM

182

183 Bank Valuation

5.2.4 Example 2: Cullen Frost

We do the same exercise for Cullen Frost Bankers, a much larger bank.

The balance sheet for Cullen Frost is as follows:

Capital Requirements for Banks: Basil I and Basil II

A series of international accords ﬁ xes standards of capital ade-

quacy for banks by classifying a bank’s capital according to its

riskiness and the ease with which it can be redeemed at the option

of the owner. A bank’s core capital is the ﬁ nancing that is not

readily redeemable by the owners and consists of Tier 1 and Tier

2 capital.

A bank’s Tier 1 capital is essentially its common stock plus its

irredeemable preferred stock. A bank’s Tier 2 capital consists of

some of the bank’s debt: Nonredeemable subordinated-term debt

(debt that will be paid out only after ordinary depositors of the

bank have been paid) and intermediate-term preferred stock. Tier

2 capital does not include most debt that is used by the bank for

ﬁ nancial intermediation and that is used for the short-term ﬁ nanc-

ing of a bank’s commercial activities.

In our valuation examples equity can be thought of as corre-

sponding to Tier 1 capital and debt as corresponding to Tier 2

capital.

184 Chapter 5

CBA

Assets:

2005 2004

Cash and due from banks

873,015,000 545,602,000

Interest-bearing deposits

6,438,000 3,512,000

Federal funds sold and resell agreements

1,033,975,000 744,675,000

Total cash and cash equivalents

1,913,428,000 1,293,789,000

Securities held to maturit

12,701,000 16,714,000

Securities available for sale, fair value

3,059,111,000 2,957,296,000

Trading account securities

6,217,000 4,671,000

Loans, net of unearned discounts

6,085,055,000 5,164,991,000

Less: Allowance for possible loan losses

-80,325,000 -75,810,000

Net loans

6,004,730,000 5,089,181,000

Sum of cash, securities, and loans

10,996,187,000 9,361,651,000

<-- =C14+C10+C9+C8+C6

Premises and equipment, net

182,356,000 170,026,000

Goodwill

168,983,000 102,367,000

Other intangible assets, net

14,903,000 14,149,000

Cash value of life insurance policies

102,604,000 105,223,000

Accrued interest receivable

276,404,000 199,371,000

Total assets

11,741,437,000 9,952,787,000

<-- =C16+SUM(C18:C22)

Liabilities:

2005 2004

Deposits:

Non-interest-bearing demand deposits

3,484,932,000 2,969,387,000

Interest-bearing deposits

5,661,462,000 5,136,291,000

Total deposits

9,146,394,000 8,105,678,000 <-- =SUM(C27:C28)

Federal funds purchased and repurchase

agreements

740,529,000 506,342,000

Subordinated notes payable and other

borrowings

188,617,000 150,872,000 <-- Longer-term borrowing

Junior subordinated deferrable interest

debentures

226,805,000 226,805,000 <-- Longer-term borrowing

Accrued interest payable and other

liabilities

456,856,000 140,695,000

Total liabilities

10,759,201,000 9,130,392,000

<-- =SUM(C31:C34)+C29

Shareholders Equity:

Common stock

550,000 536,000

Additional paid-in capital

285,802,000 212,910,000

Retained earnings

776,193,000 697,872,000

Deferred compensation

-6,175,000 -5,567,000

Accumulated other comprehensive loss,

net of tax

-50,442,000 -10,784,000

Treasury stock

-23,692,000 -72,572,000

Total shareholders equit

982,236,000 822,395,000 <-- =SUM(C38:C43)

Total liabilities and

shareholders equity

11,741,437,000 9,952,787,000

<-- =C44+C35

CULLEN FROST BANKERS, INC.

Balance Sheet

185 Bank Valuation

Notice that the liabilities of Cullen Frost are approximately equal to

the ﬁ rm’s cash, securities, and loans (the two highlighted rows). Two

items—subordinated notes and junior subordinated debentures—are

essentially long-term borrowings of the company and should not

be considered part of its working capital. Taking this fact into account,

we get the following enterprise-value balance sheet for Cullen Frost:

DCBA

Assets:

2005 2004

Short-term assets

10,996,187,000 9,361,651,000

Short-term liabilities

10,343,779,000 8,752,715,000 <-- ='Page 184'!C35-SUM('Page 184'!C32:C33)

Net working capital

652,408,000 608,936,000 <-- =C3-C4

Other assets

745,250,000 591,136,000 <-- =SUM('Page 184'!C18:C22)

Enterprise value

1,397,658,000 1,200,072,000

<-- =SUM(C5:C7)

Debt

415,422,000 377,677,000 <-- =SUM('Page 184'!C32:C33)

Equit

982,236,000 822,395,000 <-- ='Page 184'!C44

Enterprise value

1,397,658,000 1,200,072,000

<-- =C11+C10

CULLEN FROST BANKERS INC

Enterprise Value Balance Sheet

Cullen Frost’s short-term liabilities are calculated by subtracting its sub-

ordinated debt from the liabilities on the balance sheet. This longer-term

debt, not directly related to the bank’s lending activities—$415 million in

2005 and $377 million in 2004—is part of the ﬁ rm’s enterprise value.

5.3 The Bank’s Free Cash Flow

The FCF calculations for an industrial company explained in Chapters

3 and 4 have to be modiﬁ ed somewhat when considering a ﬁ nancial

company. Recall that the standard FCF calculation for an industrial

company (see Chapter 3) is along the following lines:

Free Cash Flow Calculation for a Nonﬁ nancial Company

Proﬁ t after taxes The starting point for FCF

Add back depreciation Depreciation is a noncash expense.

Subtract out increases in

operating net working capital

NWC is a ﬁ nancial burden on the company that is not accounted for

in the proﬁ t; the emphasis on operating NWC comes because we

include only items like accounts receivable, accounts payable,

inventories, etc. For purposes of calculating ΔNWC, we do not include

changes in cash (assumed to be a store of value), notes payable,

current portion of long-term debt, etc.

Subtract increases in ﬁ xed

assets at cost

This item measures the cost of purchasing new productive assets for

the company.

Add back after-tax interest

FCF is an operating concept; adding back after-tax interest costs

neutralizes the effects of interest on the ﬁ rm’s proﬁ ts.

= Free cash ﬂ ow

186 Chapter 5

This calculation has to be modiﬁ ed for a bank. On the one hand, since

cash, loans, deposits, short-term borrowings, and so forth are all part of

a bank’s productive working capital, we cannot add back the net interest

on these items.

On the other hand, the bank’s permanent capital includes

both its equity and its long-term borrowing. The “free cash ﬂ ow ques-

tion”—for a bank as for an industrial company—is, How much cash

would the company have produced were it an unlevered entity? What

complicates things for a bank is that its productive assets are debts and

loans. Our calculation for a bank’s free cash ﬂ ow is as follows:

Free Cash Flow Calculation for a Financial Company

Proﬁ t after taxes

Add back depreciation Depreciation is usually not a very signiﬁ cant item

Add back other noncash

charges

In the case of Cullen Frost, for example, we add back loan loss

provisions.

Subtract out increases in

operating NWC

Since we deﬁ ne the NWC to include deposits, etc., this step

effectively subtracts the self-funded part of the banks operations

from the FCF.

A bank’s NWC includes all short-term liabilities used to fund the

bank’s lending and investment activities.

Subtract increases in ﬁ xed

assets at cost

Note that ﬁ xed assets for banks are typically small relative to total

assets.

Add back after-tax interest on

permanent debt items (typically

long-term debt)

This step leaves the net interest income on the bank’s productive

activities—its ﬁ nancial intermediation—in the FCF calculation.

= Free cash ﬂ ow

For an all-equity bank, this ﬁ gure is equal to the consolidated cash

ﬂ ow.

For Cullen Frost, the free cash ﬂ ow can be most easily computed by

making the necessary changes to the bank’s consolidated statement of

cash ﬂ ows.

2. For an industrial company, cash is usually not part of operating working capital. (There

are exceptions, of course: A supermarket needs some money in the till.) For a bank,

however, a signiﬁ cant part of cash balances clearly constitutes a part of working capital.

See the calculation of the bank’s free cash ﬂ ow that follows.

187 Bank Valuation

BACD

Operating activities:

2005 2004 2003

Net income

165,423,000 141,325,000 130,501,000

Adjustments to reconcile net income to net cash

from operating activities:

Provision for possible loan losses

10,250,000 2,500,000 10,544,000

Deferred tax expense (benefit)

555,000 5,319,000 -3,778,000

Accretion of loan discounts

-10,124,000 -6,102,000 -4,127,000

Securities premium amortization (discount

accretion), net

329,000 1,815,000 1,167,000

Net (gain) loss on securities transactions

-19,000 3,377,000 -40,000

Depreciation and amortization

24,357,000 24,482,000 25,751,000

Origination of loans held for sale, net of principal

collected

-60,839,000 -61,035,000 -63,828,000

Proceeds from sales of loans held for sale

76,431,000 58,139,000 50,813,000

Net gain on sale of loans held for sale and other

assets

-3,418,000 -2,274,000 -3,465,000

Net proceeds from settlement of legal claims

-2,389,000 0 0

Tax benefit from stock compensation

11,371,000 11,524,000 3,638,000

Amortization of deferred compensation

1,986,000 1,377,000 833,000

Earnings on life insurance policies

-3,934,000 -4,128,000 -4,624,000

Net change in:

Trading account securities

-1,546,000 918,000 -594,000

Accrued interest receivable and other assets

-52,150,000 -30,480,000 25,334,000

Accrued interest payable and other liabilities

-23,847,000 -17,976,000 34,237,000

Net cash from operating activities

132,436,000 128,781,000 202,362,000

<-- =SUM(D3:D21)

Investing activities:

2005 2004 2003

Securities held to maturity:

Purchases

-1,000,000

Maturities, calls and principal payments

4,004,000 8,466,000 12,023,000

Securities available for sale:

Purchases

-10,763,788,000 -8,518,256,000 -8,603,817,000

Sales

19,812,000 597,369,000 6,768,029,000

Maturities, calls and principal payments

10,944,589,000 7,873,115,000 1,272,290,000

Net change in loans

-605,415,000 -581,043,000 -65,555,000

Net cash paid in acquisitions

-13,297,000 -7,063,000 -750,000

Proceeds from sales of premises and equipment

465,000 276,000 1,070,000

Purchases of premises and equipment

-18,098,000 -15,398,000 -12,512,000

Benefits received on life insurance policies

6,553,000 4,883,000 3,296,000

Proceeds from sales of repossessed properties

3,457,000 4,247,000 7,211,000

Net cash from investing activities

-421,718,000 -633,404,000 -619,715,000

<-- =SUM(D26:D37)

Financing activities:

2005 2004 2003

Net change in deposits

721,655,000 36,821,000 440,714,000

Net change in short-term borrowings

234,187,000 84,541,000 -389,417,000

Principal payments on notes payable and other

borrowings

Proceeds from junior subordinated deferrable

interest debentures

Proceeds from stock option exercises

Purchase of treasury stock

Cash dividends paid

Net cash from financing activities

955,842,000 121,362,000 51,297,000

<-- =SUM(D41:D47)

Free cash flow (FCF)

666,560,000 -383,261,000 -366,056,000

<-- =D22+D38+D48

CULLEN FROST BANKERS, INC.

Computing the Free Cash Flow from the Consolidated Statement of Cash Flows